Lehman Brothers Collapse: What Happened and Why

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Lehman Brothers collapsed because it borrowed heavily to build a large portfolio of mortgage-related assets just as the U.S. housing market turned. When those assets lost value, lenders and clients stopped trusting the firm, and no buyer or government rescue arrived. On September 15, 2008, Lehman Brothers Holdings Inc. filed for Chapter 11 bankruptcy. It was the largest bankruptcy filing in U.S. history, covering about $639 billion in assets and $613 billion in liabilities. At the time it was the fourth-largest investment bank in the United States, and its failure turned a mortgage downturn into a global financial panic.

Lehman Brothers history

The firm started as a general store founded by German immigrant brothers Henry, Emanuel and Mayer Lehman in Montgomery, Alabama, in 1844. Local farmers often paid in cotton, which pulled the business into the cotton trade. From there the brothers moved into broader commodities trading and brokerage, and in 1899 the firm began investment banking.

Over the next century Lehman grew alongside the U.S. economy and survived several crises that sank other firms: the railroad bankruptcies of the 1800s, the Great Depression and two world wars. American Express owned the firm for a period and spun it off in a 1994 initial public offering, leaving Lehman short of capital at the start of its life as an independent public company. Richard Fuld, who became chief executive around the time of the spin-off, led it through the 1998 Russian debt default and the collapse of the hedge fund Long-Term Capital Management. That record of survival helps explain why its management believed Lehman could ride out the housing downturn.

How Lehman built its mortgage business

Like many Wall Street firms in the early 2000s, Lehman moved deeply into mortgage-backed securities and collateralized debt obligations (CDOs), which pool home loans and sell investors claims on the payments. The bank earns fees for creating them and often holds some on its own books.

Lehman went further than most by owning the source of the loans. In 2003 and 2004 it acquired five mortgage lenders, including BNC Mortgage, which focused on subprime borrowers, and Aurora Loan Services, which specialized in Alt-A loans. Alt-A loans went to borrowers who did not provide full documentation of income or assets. Owning lenders gave Lehman a steady supply of loans to package, a model sometimes called vertical integration.

For several years the strategy paid off. Revenue in the capital markets unit rose 56% from 2004 to 2006. Lehman securitized $146 billion of mortgages in 2006, a 10% increase over 2005. The firm reported record profits every year from 2005 to 2007, and for 2007 it posted $4.2 billion in net income on $19.3 billion in revenue.

Why leverage made the firm fragile

Lehman’s real problem was not owning mortgage assets but how much it borrowed to own them. In 2007 its leverage ratio was about 31, meaning it held roughly $31 of assets for every $1 of shareholders’ equity.

For a hypothetical example, take a firm with $31 billion of assets funded by $30 billion of debt and $1 billion of equity. A fall of about 3.2% in asset values (roughly $1 billion) wipes out the equity, while the debt is still owed in full. At Lehman’s leverage, a modest decline in mortgage prices threatened its solvency.

The exposure was concentrated. In 2007 Lehman underwrote more MBS than any other firm and built up an $85 billion mortgage portfolio, about four times its shareholders’ equity. Much of its funding was also short-term, including repurchase agreements (repos) that had to be rolled over constantly, so it could vanish faster than assets could be sold.

Early warnings in 2007

Lehman’s stock hit a record $86.18 in February 2007, giving the firm a market value of nearly $60 billion. Within weeks, cracks in housing were visible: subprime mortgage defaults climbed to a seven-year high. On March 13, 2007, the stock had its biggest one-day drop in five years on fears that defaults would hurt profits. The next day Lehman reported record revenue and profit for its fiscal first quarter and said the risks from rising delinquencies were well contained and would have little effect on earnings.

The credit crisis broke into the open in August 2007, when two Bear Stearns hedge funds that had bet on subprime mortgages failed. Lehman’s shares fell sharply. That month it cut 1,200 mortgage-related jobs, closed BNC and suspended wholesale and correspondent lending at Aurora.

Yet Lehman stayed a major mortgage player even as the housing correction gathered pace. In the fourth quarter of 2007, global stock markets reached new highs and fixed-income prices bounced, and Lehman’s stock recovered with them. The firm did not use that window to sell down its mortgage holdings. In hindsight it was the last realistic chance to reduce the exposure at tolerable prices.

The 2008 slide

The turning point came in March 2008, when Bear Stearns nearly collapsed and was sold to JPMorgan Chase in a deal backed by the Federal Reserve. Investors immediately asked which large investment bank would be next. On March 17, 2008, Lehman’s shares dropped nearly 48%.

In April, Lehman raised $4 billion through preferred stock convertible into common shares at a 32% premium to the share price at the time, and confidence returned for a while. It did not last. Hedge fund managers publicly questioned whether Lehman was valuing its mortgage and commercial real estate assets realistically, and the stock resumed its fall.

In June 2008 Lehman announced a second-quarter loss of $2.8 billion, its first loss since the American Express spin-off, and said it had raised another $6 billion from investors. It also said it had built its liquidity pool to an estimated $45 billion, cut gross assets by $147 billion, reduced residential and commercial mortgage exposure by 20% and brought leverage down from about 32 to about 25. That same month the firm replaced its chief financial officer, Erin Callan, and its president, Joseph Gregory.

Lehman Brothers accounting practices and Repo 105

Some of the balance sheet improvement Lehman reported in 2008 was later shown to rest on an accounting technique known internally as Repo 105. After the bankruptcy, a court-appointed examiner, Anton Valukas, published a report in March 2010 describing how it worked.

In a normal repo, a firm sells securities and agrees to buy them back shortly afterward; the transaction is treated as a loan and stays on the balance sheet. In a Repo 105 deal, Lehman pledged assets worth at least 105% of the cash it received and booked the transaction as a sale rather than a loan. That temporarily removed the assets from the balance sheet. Lehman used the cash to pay down other debt just before the end of a reporting quarter, which made its leverage look lower, and then repurchased the assets days after the quarter closed. The examiner found that the firm moved about $50 billion of assets off its books this way at the end of the second quarter of 2008, and that the transactions were not disclosed to investors.

The examiner concluded there were colorable claims against senior executives and against the auditor, Ernst & Young, for their role in misleading financial statements. The New York attorney general sued Ernst & Young in 2010, and the firm later settled. No Lehman executive was criminally charged over the collapse.

The final weeks of Lehman Brothers

Over the summer of 2008, Lehman approached potential investors and merger partners without success. In the first week of September its stock fell 77% as investors doubted Fuld’s plan to stay independent by selling part of the asset management business and spinning off commercial real estate assets into a separate company.

On September 9, the state-owned Korea Development Bank put its talks about taking a stake in Lehman on hold. Lehman’s shares fell 45% that day, and the price of credit-default swaps protecting against a Lehman default rose to a record 610 basis points. Hedge fund clients began moving their assets elsewhere, and short-term creditors followed, either refusing to roll over loans or demanding more collateral.

On September 10, Lehman pre-announced a fiscal third-quarter loss of $3.9 billion, including a $5.6 billion write-down, and outlined a broad restructuring. Moody’s put the firm’s credit ratings under review and indicated that selling a majority stake to a strategic partner was the way to avoid a downgrade. A downgrade would have triggered further collateral demands. On September 11 the stock fell another 42%.

By the end of that week Lehman’s cash was running out. Over the weekend of September 13 and 14, Treasury Secretary Henry Paulson, New York Federal Reserve President Timothy Geithner and the heads of major Wall Street banks met at the New York Fed to try to arrange a takeover. Bank of America and Barclays were the two serious bidders. Bank of America instead agreed that weekend to buy Merrill Lynch. Barclays’ bid failed because it required a guarantee of Lehman’s trading obligations until Barclays shareholders could vote, and the British regulator would not waive that requirement. U.S. officials were unwilling to put public money behind the deal.

On Monday, September 15, Lehman Brothers Holdings Inc. filed for bankruptcy. Its stock fell 93% from its September 12 close.

Why only Lehman was allowed to fail

Bear Stearns had been rescued six months earlier, and within days of Lehman’s filing the government stepped in to save the insurer AIG. That inconsistency is still debated. Officials, including Paulson and Federal Reserve Chair Ben Bernanke, argued that the Fed could lend only against adequate collateral and that Lehman’s assets were not worth enough to secure the loan it needed, so they lacked the legal authority to save it without a buyer. Critics argue that the decision was partly a response to political anger over the Bear Stearns rescue and a wish to discourage future reliance on bailouts, known as moral hazard. Fuld later told the Financial Crisis Inquiry Commission in 2010 that Lehman had adequate capital and a sound business when it filed, and he criticized the government for letting Lehman go while supporting other firms.

How the collapse affected the economy

The bankruptcy hit markets through channels that few people had mapped in advance. Lehman was a counterparty to thousands of derivatives contracts, and its failure froze trades and collateral around the world. On September 16, the Reserve Primary Fund, a large money market fund that held Lehman debt, “broke the buck,” meaning its share value fell below $1. Investors pulled money from money market funds, which in turn stopped buying the short-term debt that companies used to fund daily operations.

Banks grew reluctant to lend to each other, and credit tightened across the economy. Congress passed the Troubled Asset Relief Program (TARP) in early October 2008, and governments in the U.S. and Europe moved to inject capital into banks and guarantee their debts. Stock markets fell steeply through the rest of 2008 and into early 2009.

What company acquired Lehman Brothers?

No single company bought Lehman. Its businesses were sold in pieces. Barclays bought the core North American investment banking and trading operations within days of the filing, along with Lehman’s headquarters building at 745 Seventh Avenue in Manhattan. Nomura Holdings bought much of Lehman’s business in Asia and parts of its operations in Europe and the Middle East. The asset management arm, including Neuberger Berman, was later spun out under its own management. The remaining bankruptcy estate spent years unwinding contracts and paying creditors.

FAQs

The Bottom Line

Lehman's failure matters to anyone judging how fragile a heavily borrowed financial firm can be. Record profits and a long history of surviving crises did not protect a bank funded with short-term debt and concentrated in mortgage assets. Once lenders and clients lost trust, no buyer or government rescue arrived, and the bankruptcy spread from Wall Street through money market funds, credit markets and the wider economy.